Introduction: What is the small business deduction and how does it work?
Since 1949 the federal government has afforded small businesses a reduction in income tax otherwise payable. This small business tax benefit currently takes the form of the Small Business Deduction ("SBD") under subsection 125(1) of the Income Tax Act. The purpose of the tax preference afforded to small businesses is to allow business to retain additional income to help grow the company and account for some of the disadvantages small businesses face in accessing affordable funding. Generally, the SBD provides small Canadian corporations with a deduction against tax otherwise payable on annual income up to $500,000CAD. The credit applies such that the effective federal income tax rate for small businesses is 9%. This is a 'deduction' of 19% from the corporation income tax rate of 28%. Many provinces and territories offer a similar small business deduction. British Columbia has a small business corporate tax rate of 2%, a reduction from its corporate tax rate of 12%. Similarly, Ontario has a small business corporate rate of 3.2%, down from 11.5%. The combined provincial and federal tax rates in B.C. and Ontario for businesses that eligible for the small business deduction are then 11% and 12.2%, respectively.
Eligibility Requirements for the Small Business Deduction
There are multiple requirements in order to be eligible for the small business deduction. First, the business must be a Canadian-Controlled Private Corporation ("CCPC"). Under subsection 125(7) of the Income Tax Act, a business will qualify as a CCPC if it meets three criteria:
- It is a private corporation, meaning its shares are not traded on a stock exchange;
- It is a Canadian corporation, meaning it is either incorporated in Canada or a resident in Canada; and
- It is not controlled directly or indirectly by non-residents, public corporations, or a combination of them.
Second, to benefit from the small business deduction, CCPCs must have less than $15millionCAD of taxable capital employed in Canada. The small business deduction tax credit rate of 19% will generally apply to reduce income tax otherwise payable on the first $500,000CAD of income earned annually from an active business carried on in Canada (the "business limit"). The business limit is the amount of taxable income from an active business carried on in Canada from the corporation. Canadian controlled private corporations with less than $10 million CAD of taxable capital employed in Canada will qualify for the SBD on the entire business limit amount of $500,000CAD. The business limit of CCPCs with more than $10millionCAD of taxable capital employed in Canada will be reduced according to the following schedule:
|Taxable Capital Employed in Canada ($CAD)||Business Limit ($CAD)|
A Canadian Controlled Private Corporation with more than $15million CAD of taxable capital will not benefit from the small business deduction as the business limit will be reduced to zero.
Third, to qualify for the small business deduction tax credit, a CCPC must earn income from an active business carried on in Canada. Active business income is generally defined quite broadly and includes the following:
- income from any business, other than a specified investment business or a personal service business;
- income "pertaining to or incident to" the corporation's active business; and
- income from an adventure or concern in the nature of trade.
This broad definition suggests that as long as the income is derived from business carried on in Canada and is not a personal service business or a specified investment business, the income is likely to be characterized as active business income.
Specified investment business is defined in subsection 125(7) of the Income Tax Act as any business whose principal purpose is to derive income from property. For example, a corporation that primarily earns income from property such as interest, dividends, rent, or royalties might qualify as carrying on a specified investment business.
Subsection 125(7) also provides the following four exceptions to a specified investment business, which will qualify for the small business deduction:
- a business carried on by a credit union,
- a business of leasing property other than real or immovable property,
- a business that employs more than five full-time employees throughout the year, or
- a business using services from an associated corporation that would have otherwise required employing more than five full-time employees throughout the year.
The other type of income that will not qualify for the small business deduction is income from a personal service business. A personal service business is essentially an incorporated individual who provides services. Specifically, it will be considered a personal service business if, in the absence of the corporation, the individual who both provides the service and is a specified shareholder of the corporation would reasonably be regarded as an employee of the receiver of the services.
Restrictions on Eligibility of the Small Business Deduction
In addition to the basic calculation of the SBD, there have been additional rules introduced, most recently in 2016 and 2018, to avoid corporations from unfairly benefiting from the SBD. These include special rules for associated corporations (ss. 125(3), ss. 125(5.2)), corporations with short or odd taxation years (ss. 125(5)), and corporations with passive investment income (ss. 125(5.1)).
Passive Investment Income
Amendments to the SBD to reduce a corporations eligible business limit were made in 2018 to prevent passive holding companies from benefiting from the SBD. If a corporation, or an associated corporation, earns more than $150,000 of passive investment income, the business limit of income on which it is able to access the small business deduction will be reduced to zero. The business limit will be reduced on a linear basis if a corporation earns $50,000 or more of passive investment income until the passive investment income reaches $150,000 whereupon the business limit disappears.
Subsection 125(3) of the Income Tax Act requires corporations associated with each other to file an agreement to share the amount of income eligible for the small business deduction. This rule was made to prevent individuals from incorporating several companies in order to multiply their access to the SBD.
The Income Tax Act lists five instances where corporations are associated:
- One corporation controls the other.
- Both corporations were controlled by the same person or group of persons.
- Each corporation is controlled by a person. The person controlling one corporation is related to the person controlling the other corporation. And either of those two persons owns at least 25% of each corporation.
- One corporation is controlled by a person. And that person both (i) is related to each member of a group of persons that controls the other corporation and (ii) owns at least 25% of the other corporation.
- Each corporation is controlled by a related group. Each member of one related group is related to all the members of the other related group. And one or more persons who are members of both related groups own, in total, at least 25% of each corporation.
In addition, there are multiple related rules in the Income Tax Act which elaborate upon how these five should apply in different circumstances. The rules governing associated corporations are complex and subject to numerous interpretative tax cases. Consider contacting our Certified Specialists In Taxation Canadian tax lawyer for appropriate tax guidance.
For the purposes of the reducing the business limit due to passive income earned, subsection 125(5.2) also deems corporations to be associated if 3 conditions are met: a particular corporation lends or transfers property to the other corporation; the other corporation is related to the particular corporation but not associated with it; and it is reasonable to consider on of the reasons the loan or transfer was made was to reduce the aggregate investment income of the particular corporation or an associated corporation.
Pro Tax Tips – Tax Benefits for Small Businesses: Should you incorporate your business to access the Small Business Deduction?
There are multiple factors you should consider when deciding whether incorporation is right for your business. Incorporation can provide benefits such as limited liability and tax benefits. However, incorporating also might preclude you from deducting business expenses and losses from sources of personal income such as employment income. The small business deduction is another factor to consider. While incorporating might permit your business to enjoy the small business deduction, it could also bring about a host of problems should you be unprepared, especially in regard to rules related to associated corporations and activities that don't qualify for the small business deduction. Consult one of our expert Canadian tax lawyers for income tax planning about how to properly set up your business.